z  Globalization: the Role of Institution Building in the Financial Sector _ The Case Study of China Globalization: the Role of Institution Building in the Financial Sector -The Case Study of China August, 2003 I Introduction Financial globalization could be described as a process in which global financial activities get increasingly integrated with the risk creation mechanism This description emphasizes three points First, financial globalization is not only a process in which financial activities transcend national borders, but also a process in which risks spread across the markets Second, financial globalization is initiated by many micro-economic entities to seek profits and is driven by the integration of global financial markets Third, it is a gradually deepening process with distinct phases In general, financial globalization covers five areas: capital flow, monetary system, financial markets, financial institution, and financial coordination and supervision In China, institution building in the financial sector takes place against the backdrop of financial globalization It not only shares common features with other countries’ experience but also has its own characteristics Therefore, it is useful to review the process of institution building in China, to analyze its effect on the economy and prospects under the framework of financial globalization II Review of Institution Building in the Financial Sector A Main driving forces of institution building A review of the developments of China’s financial sector over the past 20 years reveals that reform and opening up have been two major forces driving institution building in the financial sector Generally speaking, the fundamental reason for financial system reform is to increase the efficiency of allocating and utilizing financial resources The micro economic entities in the financial system initiate financial innovation through seeking for financial resources, resulting in improved efficiency of the whole financial market The reform is market-oriented and aimed to establish advanced financial system and sound financial order commensurate with the socialist market economy Endogenous institutional reform mainly depends on participation of micro entities It covers financial incentive, innovation and discipline mechanism, which drive financial development as a lasting and inherent force Opening up of the financial industry is an important part of the whole opening strategy of China Facing financial globalization, it is the rational choice for China to further open up its economy and benefit from the strategy called ‘improvement through contact’ Full-scale contact with the international markets means that China may gain access to global economic resources in a broader scope and at the same time expose the domestic financial market to the impact of the global financial markets, whether positive or negative B The role of FDI in institution building Over the past 20 years, foreign financial institutions, mainly foreign banks have played an important role in the opening up of Chinese financial industry In the early days of their operation in China, foreign banks’ deposits were generally larger than their loan portfolios, and most of the excess funds were either deposited in their overseas headquarters or correspondence banks In recent years, the growth of lending has accelerated The ratios of loan balance to total capital, total assets and deposit balance have also increased At the end of June 2003, total assets of foreign banks amounted to USD41.25 billion and total loan balance amounted to USD19.86 billion 54 percent of foreign bank loans were granted to support manufacturing industry and has promoted the development of light industry, chemical industry, and electronic industry and machinery industry Foreign banks also bring more overseas customers to the Chinese market, which has further promoted the overall increase of foreign direct investment In particular, foreign banks have provided intermediate services such as business consultation and information service in the negotiation of international loans, and such services constitute an important part in the process of attracting foreign capital In addition, foreign banks also play a unique role in institution building in the financial sector They help to mitigate financial repression in China, to establish sound financial system, to enlarge contribution of the financial sector to economic development and to realize a virtual cycle of financial deepening and economic development The role of foreign banks covers the following areas: Competition effect After the entry of foreign banks into the domestic market, the monopoly of state banks has been broken Competition forces Chinese banks to reestablish their business strategy and operation Demonstration effect Foreign banks have demonstrated their advanced technology, equipments, organization and management to domestic banks Their higher profitability has stimulated Chinese banks to upgrade technology and equipment while improving management Training effect Foreign banks provide training programs for their Chinese employees so as to improve their professional skills At the same time, foreign banks also transfer technology and management skills to their Chinese counterparts All these have helped to improve the efficiency of Chinese banks More importantly, foreign banks not only provide an external financing channel for Chinese enterprises, but also facilitate the development of the domestic capital market while they are engaged in investment and securities business Also, entry of foreign banks urges the Chinese regulatory authorities to comply with international standards and to reduce government intervention In addition, foreign banks have set a good example for Chinese banks on how to business in the international financial markets For China, the role played by foreign banks is like a double-edged sword While promoting financial deepening in China, expansion of foreign banks’ market share might have negative effects on Chinese economy, especially on the financial industry These negative impact include potential shocks to Chinese banks, strengthened transmission of international financial crisis, and reducing capability of the central bank to exercise macro-economic management using traditional monetary policy instruments C Sequencing of institution building in the financial sector The sequencing of institution building in the financial sector may differ from country to country However, there are some experiences worth mentioning for a developing country like China First, the government should base the contents and speed of reform on macroeconomic stability Second, the adjustment in financial sector should be consistent with adjustment of the real economy Third, internal adjustment should not lag far behind the process of opening up Fourth, a gradual approach should be adopted The government should take into account possible economic and social consequences, as well as the time frame required for the domestic markets to adapt to the new system and the management of enterprises to improve their professional skills In view of its overall economy, it is an inevitable choice for China to adopt a model of ‘limited opening and gradualism’ Most developing countries and a few developed countries have adopted the model of ‘limited liberalization’ When these countries opened their domestic financial markets to foreign competition, the authorities tend to set various restrictive measures in the areas of market entry and business licensing Therefore, foreign financial institutions, compared with their domestic counterparts, face more strict barriers in entering the market, conducting business and complying with regulatory rules Gradualism means that a country opens its financial markets on a gradual basis after certain conditions have been met The restrictions on market entry and business scope of foreign banks are gradually loosened and foreign banks will be granted national treatment step by step This model often involves three periods, which starts with strict restriction, then loosening restriction and ends with full liberalization As Professor Ronald McKinnon pointed out, China should adopt the gradual liberalization approach, rather than the big bang approach used by the former Soviet Union and some East European countries According to Professor Tobin, China should gradually integrate with the international financial market, though it should actively participate in the economic and trade globalization This is due to the basic economic situation and the development stage of Chinese financial market It has been proved that global financial stability requires effective surveillance and needs support from the international financial institutions However, sound macro economic policy and structural reforms in each country constitute the basis for meeting such a challenge Global financial stability is based on stability of individual country’s financial markets Also, the stability of individual country depends not only on the surveillance, guidance and support of the international financial institutions such as the IMF and World Bank, but also more fundamentally on the soundness of its monetary and fiscal policy as well as the banking system Apart from the attack of the speculators, the Asian Financial Crisis was to a larger extent caused by weaknesses in macro economic policy and the banking system in related countries D Major Issues in the institution building process of the financial sector The relationship between financial opening and financial security China’s decision to join the WTO signifies a step forward in the opening of financial sector to the outside world In the mean time, the era of rigid financial control will come to an end Coupled with the advancement of e-economy, financial opening and liberalization will bring great impact on the existing financial system, and especially on financial regulatory framework This trend also indicates the importance of financial security As far as China is concerned, financial security consists of, inter alias, the soundness of domestic financial sector and stability of the liberalized financial market The disadvantage of domestic banks in competition with foreign banks Compared with large international banks, domestic banks are generally in an apparently disadvantaged competitive position The restructuring of state-owned banks is yet to gain speed despite the significant improvement that has been achieved After China’s accession to the WTO, increasing number of foreign enterprises choose to business with foreign banks as they swarm in Meanwhile, premier domestic enterprises are also shifting to the securities market for financing, which results in the erosion of and more fierce competition in the traditional banking market The problems of inadequate innovation, weak competitiveness and the loss of premier customers and professional staff will be more salient for state-owned banks In addition, high NPL ratio poses a long-lasting difficulty for the state-owned commercial banks, which hinders the process of their ownership restructuring Moral hazard Since 1996, a set of measures has been taken by the government to prevent and dissolve financial risks However, these measures had yet succeeded in addressing the problem of incomplete contracts, but brought about moral hazard The merging and acquisition are not completely the result of market selection and the government itself took a leading role The “too big to fail” argument has been under debate in theory all the times The operation mechanism of those merged and acquired financial institutions have not changed fundamentally, however they have increased the number of branches and staff In China’s case, it is a fact that the bigger the financial institutions are, the less possible for them to be closed The government guided M&As reduces probability to fail, but it does not necessarily mean improvement of management and assets quality Weak financial infrastructure Business growth of Chinese banks is constrained by the weak infrastructure in respect of practice in loan classification, accounting, auditing and payment and settlement For instance, The NPLs of domestic banks have long been defined following traditional criteria as overdue loans, default loans and bad loans This static classification method is quite different from the international accepted methods and unable to reflect the true quality of loans In recent years, the application of the fivecategory classification method has been advanced thanks to the strong push of the central bank and the efforts of commercial banks Slow progress in market-based interest rate reform Since interest rates are not adequately determined on market basis, their roles as signals to the supply of and demand for fund are not fully effective, and sometimes have negative influence on pricing and risk management of commercial banks E Policy measures to promote institutional building Institution building in financial sector in China has been mainly achieved through a series of institutional reforms China’s financial institutional reform process could be divided into the following three stages: (1) preparation and strategy exploration, (2) framework construction, and (3) adjustment and advancement During the first stage from 1979 to 1984, the financial sector in China began to undergo institutional reform The prominent features of the financial system at this stage could be summarized as follows: (1) separation of central banking from commercial banking by establishing a twotier banking system, (2) establishment of specialized commercial banks serving different industries; and, (3) Introduction of deposit based bank growth model During the second stage from 1985 to 1996, a series of new arrangements and a primary framework for market-based financial operations were introduced The main features are as follows: (1) The legal status of the central bank was established with the promulgation of the Central Bank Law and the Regulations on Monetary Policy Committee (2) The institutional structure diversified, including the development of nonbanking financial institutions, the establishment of several insurance companies, the fast growth of securities industry, the start-up of Shenzhen and Shanghai Stock Exchanges and the grant of market access to foreign financial institutions (3) Significant progress was made in financial deregulation, including the separation of commercial banking from policy banking by establishing three policy banks in 1994 and the promulgation of Commercial Banking Law in 1995, encouraging competition among banks, introducing concept of risk, profitability and cost in bank management, improving capital management system, introducing assets/liability ratio regulatory framework, and strengthening internal control (4) Macro financial management relied more on indirect adjustment than on direct control, with extensive application of monetary policy instruments such as interest rate, reserve requirement and open market operations, while focus of supervision of commercial banks shifted from credit ceiling to a comprehensive set of prudential ratios (5) Remarkable progress was achieved in institutional innovation of the financial market Stock exchanges, inter-bank market and bills market began to operate During the third stage from 1997 till now, the development of a buyer’s market entailed adjustment and consolidation in the process of financial institution building The main features were as follows: (1) Transferring the non-performing assets of commercial banks to the newly established AMCs; (2) Improving the segregated financial supervisory system by establishing Securities Regulatory Commission, Insurance Regulatory Commission and Banking Regulatory Commission, and replacing 32 provincial branches with nine regional branches of the central bank; (3) Accelerating capital market development by improving its functions and expanding market capitalization; (4) Accelerating restructuring of the state-owned commercial banks and putting property right reform on the agenda; (5) Rectifying financial order to prevent financial risks; (6) Stimulating domestic demand and combating deflation by implementing a sound monetary policy; (7) Expanding the scope of financial service and initiating consumer credit market; and (8) The emergence of extensive cooperation among banking, insurance and securities industries has created the conditions for providing universal-banking services in the future To sum up, China’s financial system reform in the past two decades has been characterized by institutional innovation, namely the change from planned financial system to market-oriented financial system and the change from one-tier banking system to two-tier banking system First, the direct policy instruments for macro-economic management has given way to indirect to market instruments The central bank shifted its reliance on direct control of credit ceilings and currency issuance to market instruments such as reserve requirement, interest rate, central bank lending and open market operations in recent years to adjust money supply During this process, the channel for base money supply has been evolving from through central bank lending to purchasing foreign assets and open market operations At the same time, the spectrum of institutions has become more diversified with the establishment of 10 joint stock commercial banks, 100 city commercial banks, large number of urban credit cooperatives, trust and investment companies together with finance companies, financial leasing companies and fund management companies F Role of the government, central bank and international financial institution in institution building Role of the government As an indispensable part of the financial system, supervision and regulation of the government have strong influence on the behavior of microeconomic entities Aiming at mitigating risk and encouraging competition, the supervisory authorities adjust financial framework and promulgate supervisory regulations The regulations may have impediments on banks’ activities However, banks may also initiate some new financial activities in order to enhance their profitability Also they may create some new operating models, such as new organizational structure or new financial products, which go beyond the existing supervision boundary Nevertheless, the authorities may regard these initiatives as evasion of financial supervision and therefore, work out new regulatory measures to follow such development Nonetheless, a neutral solution would be finally found to balance the cost and benefits for various sides as the pressures increasingly mount on the authorities Lastly, financial innovation and the economic environment tend to be mutually reenforcing When reviewing the whole process of financial restructuring in China, it is not difficult to find the pervasive role played by the government Intervention by the government in different ways and of different purposes has different effect on the arrangement of reform An exogenous intervention of the authorities on the financial industry would cultivate the exogenous features of the institutional reform, which would constitute external pressure on the financial institutions Therefore, such a reform would be less forceful in improving microeconomic performance Role of the central bank The central bank has played a role of policy designing and implementation in the process of institution building in the financial sector The promulgation of The Central Bank Law in March 1995 has legally confirmed the status and responsibility of the People’s Bank of China (PBC) as the central bank With dual responsibilities on monetary policy and financial supervision, the PBC has designed and implemented a serious of financial reform programs under the leadership of the State Council and with collaboration of relevant government ministries In the process of designing reform programs, the PBC has learnt from valuable experiences of the developed economies and followed the principles of market economy at the same time For instance, after learning from experiences of several countries, the organization of the PBC has undergone a break-through reform in 1998, with the restructuring of 32 provisional branches into regional branches By doing so, the PBC has accomplished a historical transition in its administrative regime by replacing its provincial branch network with regional branches set up in accordance with regional economic development As a result, the independence of the central bank in implementing monetary policy and financial supervision has been strengthened While learning experiences from other countries in the restructuring process, the PBC has never neglected the specific situation in China For instance, China has enjoyed strong balance of payments position after achieving current account convertibility of the Chinese currency in December 1996, resulting in a stable exchange rate and a sustained growth of its foreign exchange reserves As international experience shows, capital account convertibility requires stable macroeconomic environment, a healthy financial system, effective financial supervisory framework and enduring national strength While some emerging economies in Asia such as Thailand, Malaysia and Korea have abolished control on capital account transactions and realized full convertibility of their currencies; China still sticks to the ‘gradualism approach’ in promoting capital account convertibility The existing deficiencies in the economic fundamentals call for prudent liberalization It was such an arrangement that has put China in a better position to confront the challenge arising from the Asian Financial Crises At the same time, we have successfully prevented the negative impact of the confidence crisis on Chinese economy and competitive currency depreciation, which have in turn contributed to the financial stability not only in Asia but also in the whole world Role of the international financial institutions ( IFIs ) The IFIs have played an active role in financial restructuring in China by introducing international standards and good practice and providing policy advice and personnel training in specific areas For instance, China has established its external debt surveillance system with the assistance of the Bank for International Settlements Also, technical assistance from the World Bank has contributed to the establishment and application of the five-category loan classification system in Chinese banking industry Actually, all domestic commercial banks adopted the five-category loan classification system in early 2002 The idea of setting-up four AMCs to dispose jof non-performing loans of the state-owned banks and the practice thereafter have also benefited from technical assistance of the World Bank China has taken active measures to increase its transparency and meet relevant international standards and guidance since its WTO accession Efforts have been made to further increase the transparency of macroeconomic statistics, fiscal policy, monetary policy, banking information disclosure, as well as the securities and insurance industries New improvements have been made in promotion of good governance structure as well as implementation of international accounting standards In general, these measures have gained wide international acclaim G The role of new technology in institution building With fast development of modern information technology and financial engineering in recent years, the tendency of providing financial services through the Internet has become increasingly clear Though threat from e-commerce on the traditional commercial services have been somewhat limited due to inconvenience of goods distribution, challenges of on-line financial services to the traditional banking services would go beyond any technical barriers, because the nature of on-line financial service is the processing of information The fast development of the Internet technology has influenced substantially the economic and financial behavior, and it indicates the arrival of the era of competition for on-line financial transactions, and it may also bring about a huge shock to the traditional business of the financial industry Foreign banks stationed in China will be national treatment of foreign banks are being phased in line with China’s WTO commitment, and the original geographic and customer restrictions on foreign banks regarding their foreign exchange and RMB business will also be phased out With strong portfolio and rich experience, foreign banks could expand quickly their market shares through on-line banking and overcome their limited business network and outlets On the contrary, the original strength possessed by domestic banks in terms of geographic distribution would be weakened, which may have negative impact on domestic banks At the moment, corresponding regulations on on-line banking service are yet to be put in place, the same situation may also apply to those regulations regarding the security certification system as well as the modernized payment system We have realized that a considerable gap does exist between China and the developed countries either in the area of information technology and quality control on credit assets or in financial risk prevention In light of this situation, commercial banks in China need to strengthen development of information technology by cooperating with each other and mobilizing the best resources among themselves, so as to reduce the cost of management and business development By large, domestic financial institutions should not only focus their attention on innovation of financial products, but also make due efforts in the application of information technology, in exploring on-line banking business as well as in promoting non-bank financial institutions Efforts should be made in upgrading financial operations and financial services, and in conducting systematic study on banking business development, its security system, risk prevention as well as supervision Formulation of relevant policy and regulations should aim to promote healthy development of on-line banking services in China The substantial changes in financial system and technology mentioned above have posted great challenges to China’s financial and supervisory system From technical point of view, non-bank financial institutions or even non-financial institutions are able to evade supervisions due to swift development of on-line financial services Therefore, either opening of financial markets or development of internet-based financial services will constitute big challenges to both the monetary authority and the financial supervisory authorities III Institution Building of the Chinese Bond Market A Current stage of the Chinese bond market Prior to 1997, China’s bond market mainly comprised exchange-based bond transactions and over-the-counter (OTC) transactions of bearer’s treasury bonds at banks Due to the different trading terms issued in these two markets, transactions between them could not be fulfilled Volatility of the stock markets has significant development of this market and construction of the market mechanism by adopting effective measures First, the central bank acted as the designer and promoter of the OTC market in China The inter-bank bond market was actually organized and established by the central bank Marco-economic policy measures taken by the government since 1997 have also contributed to the rapid development of the inter-bank market In April 1998, in order to support the reform on commercial bank’s required reserves; the Ministry of Finance (MOF) issued RMB270 billion yuan of book entry treasury bonds to the state-owned commercial banks, and RMB42.3 billion yuan special treasury bonds to other commercial banks Since 1998, while Chinese government adopted proactive fiscal policy to boost domestic demand, the MOF and policy banks have issued large amount of treasury bonds and policy financial bonds, which resulted in substantial increase of outstanding bond balance in the inter-bank market Since 1998, the central bank has gradually relied its monetary policy operations mainly on open market operations (OMOs), while at the same time the inter-bank market has become the major market place for the OMOs and its liquidity has seen continuous increase Second, the central bank encouraged market-based bond issuance, drawing on good international practice Before 1998, treasury bonds were mainly issued in the form of bearer certificate and purchased by all types of investors, while policy financial bonds were issued by compulsory allocation Those issuance practices undermined financial institution’s asset management capability and also harmed operation and development of the inter-bank market In 1998, the central bank promoted the market-based bond issuance of policy financial bonds and finally made possible the bidding-based issuance of treasury bonds in 1999 Moreover, the central bank has made continuous efforts to enhance the construction of market infrastructure Under the instruction of the central bank, the CGSDTC developed and improved the bond depository and clearing system, strengthening risk prevention capability of the market The central bank also guided China inter-bank funding center and the CGSDTC to computerize their trading system, centralized book-entry system, bond issuance system and OMOs system, and upgrade these systems in accordance with the changing market demands from time to time It organized the CGSDTC and commercial banks to develop the second-tier depository system supporting transactions of book-entry treasury bonds through outlets of commercial banks, establishing a mechanism for depositors, traders and clearing clients to supervise each other, which ensured the sound operation of the bond market C Positive implications of bond market development Development of bond market in China provided important market conditions and market mechanism for macroeconomic management and financial institutions’ operations First, it supported the implementation of proactive fiscal policy and facilitated the issuance of treasury bonds and policy financial bonds From 1998-2002, treasury bonds issued by the MOF totaled RMB2158.6 billion yuan, financial bonds issued by the policy banks totaled RMB929 billion yuan The bond market has played an important role in government’s efforts to boost domestic demand and stimulate 11 economic growth Second, bond market provided a solid foundation for the central bank to exercise indirect financial management Since 1998, OMOs has become the most important instrument for the central bank’s day-to-day monetary policy operations As a matter of fact, the effectiveness of OMOs depends on precise comprehension of central bank’s policy stance by participants of the inter-bank market Thanks to market participants’ sensitivity to its policy signals, the central bank is able to transmit monetary policy through the inter-bank bond market on a timely basis, and thus ensure the effectiveness of its policy Development of bond market is also conducive to the advancement of the market-based interest rate reform After the establishment of inter-bank bond market, repo rates were completely determined by both trading parties, while the issuance rate was determined through public bidding The central bank’s successful deregulation of interest rates in the inter-bank market has provided useful experience for further steps of interest rate reform In addition, bond market development also made financial institutions’ portfolio adjustment much easier Previously, China’s commercial banks had rather simple balance sheets, which only consisted of loans on the asset side and deposits on the liability side Such a structure constituted a constraint on commercial banks’ business development Along with the bond market development, such a simple structure was essentially improved Bond holdings accounted for an increasing proportion of commercial banks’ total assets, which to some extent contained the rising risk originated from dominance of loans in the total assets and helped to improve the asset quality Besides, active trading on the bond market has facilitated the improvement of commercial banks’ liquidity management D Blueprint for the construction of China’s bond market In comparison with developed market economies, there is still much room for China’s bond market development The advance of China’s economic and financial reform also entails the rapid development of bond market With regard to the financing system, intermediate financing, particularly financing through the banking system, still takes a dominant position, while direct financing only accounts for a rather small portion Firms’ over-reliance on intermediate financing, mainly banking loans, has become one of the major problems yet to be addressed With regard to macro-economic management, bond market is the connecting point for monetary policy and fiscal policy Given that household savings and corporate deposits still account for a significant component of overall financial assets, commercial banks will be the major buyer of treasury bonds and consequently important supporters of the proactive fiscal policy in the future While ensuring the issuance of treasury bonds to raise funds for capital replenishment, the central bank should inject liquidity to the inter-bank bond market through OMOs and provide sufficient funding sources for private investment, so as to avoid the “crowding out” effect of the fiscal policy Additionally, coordination between policies for domestic currency and foreign currencies also entails the support of bond market development In the past several 12 years, the amount of base money has increased rapidly due to the accumulation of foreign exchange reserves In order to prevent the excessive growth of money supply, the central bank has to conduct sterilization operations through OMOs, which essentially depends on bond market development The objective of China’s bond market development is to establish a nationwide unified market for all financial institutions, corporate legal entities and retail investors, which shall include various sub-markets with specific functions Such a market shall be mainly founded on an OTC wholesale market and complemented by the exchange retail market To develop bond market, it is crucial to promote construction of the bond market infrastructure: Establishing credit rating agencies for the bond market In China’s bond market, there is still no independent, fair and authoritative credit rating agencies for bond issues, neither are there rules and standards for regular information disclosure of bond issuers In order to meet the need of non-government entities, particularly commercial institutions to issue debt instruments on money market or bonds on bond market, a standard, transparent and fair credit rating system should be put in place Improving market-based issuing practice, increasing supplies and products of bond issues Efforts will be reinforced to develop corporate bond market, promote securitization of banks’ portfolios Regular, balanced and rolling over treasury bond issues of all maturity, including short, medium and long term, will be ensured Bond instruments of a diversified spectrum of risk profiles and maturity will be introduced, so as to maintain a balanced development of the overall bond market Unifying the segregated bond market After commercial banks’ exit from the exchange market in 1997, China’s treasury bond market has been divided into three separate sub-markets, including the inter-bank bond market, exchange bond market and OTC market of commercial banks The trading system of bond market will be unified, so as to enhance the linkage among these three sub-markets Consequently, one bond issue can be transferred among these sub-markets, traders are able to freely choose market place and trading system that better suit their needs, and funds can flow freely among the different sub-markets Establishing market intermediaries and improving liquidity of the secondary market Market-maker system shall be introduced to the bond market and improved on the basis of the existing two-way quotation trading system, so as to improve market liquidity The rights and obligations of the market maker shall be modified and clarified and policy and technical support will be put into place to enable the market maker to play their role in maintaining market liquidity In addition, brokerage system will be promoted Trading on the inter-bank bond market is based on bilateral negotiations between traders, therefore complete and timely information is of vital importance to the market participants Brokers can provide information for traders and facilitate the matching of business trading, therefore market efficiency can be improved and trading cost reduced Hence, permission for eligible traders to engage in brokerage business or establishing brokerage firms will be taken into account to facilitate bond brokerage business Bond derivatives may be introduced at proper time to provide hedging instruments for bond traders 13 Improving bond depository and settlement system Bond trading, depository and settlement system will be upgraded on a timely basis to meet the need of rapidly developing market DVP settlement for bond transactions will be adopted in the near future to prevent settlement risk The computerized trading system of China Interbank Funding Center shall be renovated by introducing facilities such as anonymous quotation and anonymous clicking to strike deals and introducing brokerage functions for on-line transactions Bond trading system and settlement system shall be connected as soon as possible, which will improve trading efficiencies on the bond market IV Impact of Financial Sector Developments on Economic Growth A Rapid growth of financial assets resulted in a higher financial assets/ GDP ratio In the past 20 years, with the deepening of the financial markets, rapid development has been witnessed in the banking, securities and insurance sectors As a result, with the volume of financial assets rising from RMB437.9 billion to RMB25 trillion, the aggregate financial assets to GDP ratio jumped from 1.07 in 1980 to 3.20 in 1999 (Graph 1) Financial Assets/GDP Ratio 5 5 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 Graph Trend of Financial Assets/GDP ratio The variety of financial assets consists of bank deposits and loans, stocks, bonds and insurance premiums With the rapid growth of the money market and capital market, deposits and lending of financial institutions continued to be the dominant financial assets, even though their proportion declined in the 1990’s from 86.28 percent of 1991 to 77.1 percent of 1999, while equities, bonds and insurance premiums accounted for only 17.2 percent of the total by the end of 1999 14 Table Structure of Financial Assets Year Mo Deposits with FIs Loans of FIs Borrowin Bonds g by the Ministry of Finance Capitalizat Insurance Total ion of A Premium Financial Share and s Assets B Share Markets 1980 346.2 1661.2 2414.3 170.2 258.44 4850.34 1981 396.3 2027.4 2860.2 170.2 258.44 5712.54 1982 439.1 2369.9 3180.6 170.2 258.44 6418.24 1983 529.8 2788.6 3589.9 199.6 258.44 7366.34 1984 792.1 3583.9 4766.1 260.5 258.44 9661.04 1985 987.8 4264.9 5905.6 275.1 258.44 25.73 11717.57 1986 1218.4 5354.7 7590.8 370.1 339.6 42.35 14915.95 1987 1454.5 6517 9032.5 515 540.79 10 67.14 18136.93 1988 2134 7425.8 10551.3 576.5 935.87 35 94.76 21753.23 1989 2344 10786.2 14360.1 684.6 1142.81 41.62 122.91 29482.24 1990 2644.4 14012.6 17680.7 801 1343.4 45.9 155.76 36683.76 1991 3177.8 18079 21337.8 1067.8 1700.48 109.19 209.7 45681.77 1992 4336 23468 26322.9 1241.1 2540.15 1048.13 335.15 59291.43 1993 5864.7 29627 32943.1 1582.1 3478.17 3531.01 456.87 77482.95 1994 7288.6 40472.5 40658.3 1687.1 3927.59 3690.62 376.41 98101.12 1995 7885.3 53862.2 50538 1582.1 5566.69 3474.27 453.3 123361.86 1996 8802 68571.2 61152.8 1582.1 7379.61 9842 538.3 157868.01 1997 10177.6 82390.3 74914.1 1582.1 9917.25 17529 772.7 197283.05 1998 11204.2 95697.9 86524.1 1582.1 13822.26 19506 1255.9 229592.46 1999 13455.5 108778.9 93734.3 1582.1 17346.46 26471 1406.2 262774.46 Sources: China Statistics Yearbook, China Financial Yearbook and People’s Bank of China Statistics Quarterly bulletin B Development of direct financing and indirect financing markets providing financing sources for enterprises With deepening of the financial markets, enterprises more often resort to banks for credits As the role of government in providing financing gradually faded out, the 15 inter-mediation function of the banking sector started to play an increasingly important role (Graph 2) Given the disadvantages associated with using fiscal funds to satisfy investment thirst of the State-owned enterprises (SOEs) and soft budget constraint, changes have been made to the old financing system since the reform started in 1978 In 1979, fiscal funds were replaced by bank credits on a trial basis in capital investments The full implementation was launched in all budgeted capital construction projects in 1985, as a result, the proportion of fiscal funds declined dramatically and bank credit became an important financing resource for enterprises By 1999, the proportions of fiscal funds, bank credits, foreign financing, self-owned capital and other financing sources in gross fixed capital investments were 6.2 percent, 19.2 percent, 6.8 percent and 67.8 percent respectively Although self-owned capital made up 60 percent of enterprise financing, taking 1997 as an example, outstanding balance of bank credits amounted to RMB8 trillion yuan, foreign investments RMB3 trillion yuan and stocks RMB 400 billion yuan As the state-owned commercial banks have extended 60 percent to 70 percent of the total outstanding loans, they become the dominant providers of indirect financing and the most important source of financing for enterprises, if their own capital is excluded In summary, the deepening process of the financial markets has rendered the dominance of the banking sector in the financial system At the same time, opening of markets and reforms have contributed to the strengthening of intermediation function of financial markets, with household savings as a major source of national savings and bank lending as a major source of enterprise financing 80 70 60 Domestic Credit State Budget foreign funds Self-finance and Others 50 40 30 20 10 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 Graph Financing Sources of Enterprises C Monetarization of the economy sharply increased The monetarization of an economy is measured by the M2/GDP ratio, of which, M2 is broad money that equals to the sum of currency in circulation, demand deposits and time deposits, which can also be considered as the aggregate money supply M2/GDP ratio is an indicator to measure the financial deepening of developing economies Using this ratio, Professor Ronald Mckinnon analyzed the gap in financial deepening between the developed and developing countries and the process of financial deepening in the developing countries He suggests that as financial 16 deepening goes further, the M2/GDP ratio increase in developing countries As Graph indicates, since the reform and opening to the outside world, China’s M2/GDP ratio climbed rapidly along with the deepening of financial markets Financial Deepening: M2/GDP 1.6 1.4 M2/GDP M2/GDP 1.2 0.8 0.6 0.4 0.2 1999 1997 1995 1993 1991 1989 1987 1985 1983 1981 Graph Financial Deepening in China In this study, the M2/GDP ratio of China was compared with those of a few other countries Table shows that China’s M2/GDP ratio is similar to those of Japan and UK, but higher than those of Korea and the United States1 Table M2/GDP in China, Japan, Korea, UK and United States Year China Japan Korea UK United States 1992 1.066 1.076 0.400 0.962 0.633 1993 1.008 1.090 0.420 0.954 0.612 1994 1.004 1.114 0.435 0.961 0.578 1995 1.038 1.135 0.437 0.966 0.584 1996 1.120 1.108 0.457 1.086 0.588 1997 1.216 1.140 0.483 1.045 0.592 1998 1.333 1.206 0.575 1.073 0.621 1999 1.461 Sources: International Financial Statistics, August, 2000 and China Financial Outlook Indeed, we cannot reach the conclusion for granted that China’s financial sector is more advanced than that of Korea and the United States In this sense, M2/GDP is only one of the indicators of how developed a country’s financial sector is The low M2/GDP ratio in the United States is due to the fact that in addition to bank credits, enterprises can substantially raise funds from other sources, such as the capital market 17 The rising trend in the M2/GDP ratio is partially due to the continued monetarization of China’s economy Professor YI Gang made the hypothesis that the rising trend of money supply to GDP ratio is the result of monetarization of China’s economy and came up with supporting evidence of money in circulation Since the beginning of reform and opening of the market, monetarization of transactions has become more common Goods that were provided by the government at low price or free began to be traded at market prices and goods used to be inaccessible in the market became available The role of money as the media of exchange has become increasingly significant and the demand for money has been growing accordingly The other reason that China’s money supply to GDP ratio has been rising is the rapid growth of quasi-money As the reform and opening to the outside world gradually unfolded, the proportion of household income in national income has kept growing Given the fact that bank deposit constitutes a safe and liquid investment generating stable income, it has become the dominant investment product for households, which in turn has become the most important source of deposits Meanwhile, due to limited investment choices, households’ investment is largely confined to bank deposit In summary, the rapid growth of M2/GDP ratio is the consequence of financial deepening and a reflection of the unique feature of the structure of financial assets 18 Appendix Tables: Table Structure of Financial Assets (in Percentage) Domestic Insurance Premiums Year M0 Loans & Deposits Bonds 1980 7.14 84.03 5.33 1981 6.94 85.56 4.52 1982 6.84 86.48 4.03 1983 7.19 86.59 3.51 1984 8.20 86.43 2.68 1985 8.43 86.80 2.21 0.22 1986 8.17 86.79 2.28 0.28 1987 8.02 85.73 2.98 0.06 0.37 1988 9.81 82.64 4.30 0.16 0.44 1989 7.95 85.29 3.88 0.14 0.42 1990 7.21 86.40 3.66 0.13 0.42 1991 6.96 86.29 3.72 0.24 0.46 1992 7.31 83.98 4.28 1.77 0.57 1993 7.57 80.75 4.49 4.56 0.59 1994 7.43 82.70 4.00 3.76 0.38 1995 6.39 84.63 4.51 2.82 0.37 1996 5.58 82.17 4.67 6.23 0.34 1997 5.16 79.74 5.03 8.89 0.39 1998 4.88 79.37 6.02 8.50 0.55 1999 5.12 77.07 6.60 10.07 0.54 Stocks 19 Table Financing Sources of Business Investments Year State Budget Domesti Foreign c Credit Capital Self-Owned and Others 1981 28.1 12.7 3.8 55.4 1982 22.7 14.3 4.9 58.1 1983 23.8 12.3 4.7 59.2 1984 23 14.1 3.9 59 1985 16 20.1 3.6 60.3 1986 14.6 21.1 4.4 59.9 1987 13.1 23 4.8 59.1 1988 9.3 21 5.9 63.8 1989 8.3 17.3 6.6 67.8 1990 8.7 19.6 6.3 65.4 1991 6.8 23.5 5.7 64 1992 4.3 27.4 5.8 62.5 1993 3.7 23.5 7.3 65.5 1994 22.4 9.9 64.7 1995 20.5 11.2 65.3 1996 2.7 19.6 11.7 66 1997 2.8 18.9 10.6 67.7 1998 4.2 19.3 9.1 67.4 1999 6.2 19.2 6.8 Capital 67.8 Sources: Almanac of China’s Finance and Banking and China Statistical Year Book V An Outlook of Institutional Reforms in the Coming Years In light of the opportunities and challenges posed by China’s accession to WTO and the prospect of economic and financial globalization, the coming years are regarded as another key period for China’s financial reform Our only choice is to 20 accelerate the reform and further opening up financial sector, improve competitiveness of China’s financial institutions and create a sound and liberalized financial environment With China’s entry into WTO, the financial industry face great challenges, which include the following aspects: i China’s financial supervisory system falls behind regulatory requirement; ii The underdeveloped financial market constrains rational resource allocation and sound macroeconomic management; iii The wholly state-owned commercial banks are yet to be transformed to be modern commercial banks, and iv There are potential risks in the rural financial system Consequently, China will continue to deepen its financial reform, improve institutional system, market system, and supervisory system and management system of the financial sector In particular, we will i Continue the sound monetary policy to appropriately adjust money supply and to support economic restructuring and growth; ii Prevent and mitigate financial risks and improve asset quality of banks; iii Implement comprehensive reforms on the wholly state-owned commercial banks in line with international practice; iv Reform rural financial system and extend further credit support to farmers, agriculture and rural economy v Keep strong balance of payments position and improve managed floating exchange rate regime based on market supply and demand of foreign exchange Details of the reform measures are as follows: A Improve monetary policy conduct China will continue to implement the sound monetary policy and improve monetary policy mechanism mainly based on indirect instruments First, open market operations will be expanded, with its decision-making mechanism improved and direction and intensity rationally decided and timely adjusted In terms of operations, we will increase trading frequency and introduce minor adjustment While enlarging the trading volume of repurchase, we will enhance operations in the outright spot market of government bonds We will choose trading method in a flexible way and introduce the role played by open market operations in directing and adjusting shortterm market rates Primary dealers will be encouraged to play active roles in increasing market liquidity and transmitting monetary policy intentions The infrastructure of open market operations will be strengthened and payment system improved 21 Market-based interest rate reform will be gradually advanced and an interest rate system with the central bank rate as benchmark and deposit and lending rates of financial institutions determined by market supply and demand of funds will be established The interest rate reform will follow the sequence of foreign currency before domestic currency, rural financial institutions before urban financial institutions, and lending rate before deposit rate The detailed plan is as follows: interest rates of domestic corporate bonds will be fully decided by the market; deposit and lending rates charged by rural credit cooperatives (RCCs) will be purely based on supply and demand of funds in the rural areas and the risk of lending; the floating band for lending rate of urban financial institutions will be further expanded while control of general deposit rate continues to stand and large-value deposit rates are managed with flexibility B Implement comprehensive reform on state-owned commercial banks in line with international practice The general objective of reform and development of the wholly state-owned commercial banks is to deepen institutional reforms, enhance ownership structure, and improve corporate governance, operational mechanism, personnel and incentive system, so as to bring down the ratio of non-performing loans below 15% and keep the capital adequacy ratio above 8%, while maintaining profit growth at the same time The priority of the reform is to establish a modern banking system around 2005 through equity restructuring of the banking sector, especially of the big four wholly state-owned commercial banks The main contents of the reform include the following: i To introduce ownership and equity reform First, commercial banks will be encouraged to operate based on commercial principles Second, an efficient internal corporate governance system will be established Third, some of the state-owned commercial banks that meet certain criteria will be restructured into joint-stake banks with the state holding the controlling stake, which would pave the way for these banks to go public later ii To streamline branch network The branch network will be streamlined following the principle of retrenchment, efficiency and profitability Meanwhile, internal organizations will be set up according to the rule of rational division of labor and mutual restraint iii Prudential accounting system will be introduced and historical burden gradually solved to improve asset quality Accounting standards will be modified, the system of establishing provisions for and writing off bad loans reformed, the business tax on commercial banks reduced and five-category loan classification system more extensively applied iv To increase capital adequacy ratio through various channels while introducing and perfecting capital replenishment mechanism of commercial banks 22 v To improve external supervision on commercial banks and take two steps to strengthen transparency of state-owned commercial banks so that information disclosure of China’s banking industry would meet the international standards The first step is to revise the accounting system of banking industry for the purpose of encouraging commercial banks to disclose information of nonperforming loans and increase disclosure frequency The second step is to further disclose information on performance and financial situation of the commercial banks so as to meet international standards In addition, commercial banks will be encouraged to develop new business products and improve incentive scheme C Deepen the reform of Rural Credit Co-operatives (RCCs) and improve financial services in the rural area The reform of RCCs should aim ‘to clarify ownership, strengthen disciplinary mechanism, reinforce functions in financial services, seek appropriate government support and hold local governments accountable’ In line with these principles, RCCs will be turned into local community financial institutions where farmers, rural businesses and other various economic entities jointly hold the stock, thus becoming a financial institution specializing in providing services to farmers, agriculture and the rural economy Internal control and operational mechanisms of the RCCs will be further strengthened to prevent and mitigate financial risks confronting the RCCs Besides, the RCCs should be encouraged to act as the main financial force to support economic structural adjustment in the rural area, help farmers to increase income and promote the harmonious development of urban and rural economy D Speed-up development of the financial market The financial market is an important transmission channel for monetary policy and its development not only has impact on the financing efficiency but also on the efficiency of monetary policy operation Therefore, China needs to accelerate the development of the financial market First, a unified money market with different levels and open to all financial institutions will be established i Further regulate and develop the inter-bank market by increasing market participants and expanding the intermediary roles of the small and mediumsized financial institutions; ii Develop over-the-counter trading of bonds and related settlement business for corporate and individual investors, and establish a unified bond market with the inter-bank bond market as the main-play, complemented by over-the-counter trading bonds in commercial banks Meanwhile, the system of bond depository, payment and settlement will be improved; iii introduce brokers and market makers to the money market; iv Encourage financial institutions to develop the business of bills discount, promote the development of regional bills market, introduce financing bills and accordingly promote diversification of instruments in the bills market 23 Second, development of China’s capital market will be advanced There are three priorities in the reform of the capital market, including strengthening corporate governance, improving market institutions and upgrading supervisory skills For the purpose of protecting investors, operation of listed companies and security firms will be regulated to increase information disclosure Third, interactions between money market and capital market will be established, support the development of capital market, prevent financial risks and further improve the depth and breadth of the impact of monetary policy on macro economy E Improve the managed floating exchange rate regime of RMB In 1994, a unified, managed floating exchange rate regime based on market supply and demand of foreign exchange was introduced in China There is no denying the fact that the current exchange rate regime needs to be improved We should improve the managed floating exchange rate regime based on stability of RMB For that purpose, China will gradually enhance the role of the market in the formation of exchange rate, and improve administration policy for banks’ foreign exchange position resulting from purchase and sale of foreign exchange and the arrangement of compulsory sale of foreign exchange Meanwhile, the following measures will be taken to further develop the foreign exchange market: i introduce forward contracts in purchase and sale of foreign exchange, ii extend business hours of the inter-bank foreign exchange market, iii diversify trading products in the foreign exchange market, iv improve intervention by the central bank, v modify the management goal of RMB exchange rate, and vi Strengthen surveillance and early-warning mechanism of the foreign exchange market F Gradually remove capital account control China will gradually create conditions with prudence for capital account liberalization by taking the following efforts: i gradually apply market instruments such as interest rate, tax rate and exchange rate to manage domestic economy for the purpose of achieving overall macroeconomic balance; ii strengthen the capability of domestic enterprises and financial institutions in terms of self-development and self-discipline so as to improve their efficiency in the use, earning and repayment of foreign exchange; iii improve the government’s fiscal position; 24 iv keep price stability; v regulate development of the financial market, especially the operation of the securities market; and vi Improve financial supervision to prevent shocks brought by flow of international capital G Further open the financial market China’s following commitment to opening financial market under the WTO’s framework will be strictly honored: i foreign exchange business for domestic enterprises and residents has been liberated for foreign banks upon China’s WTO accession, and ii RMB business for domestic enterprises are being open for foreign banks within two years of WTO accession and RMB business for domestic residents will be liberalized within five years of WTO accession Within five years from WTO accession, the number of cities where foreign banks are allowed to operate RMB business will be gradually increased Five years after WTO accession, foreign banks will be permitted to RMB business without any geographical restrictions and enjoy complete national treatment H Strengthen financial supervision to assure national economic and financial security A country’s economic and financial security largely depends on the soundness of its banking supervisory system that meets the international standards The set-up of China Banking Regulatory Commission will help enhance independence and professionalism of the supervisory authority and intensify its capability in deterring moral hazard and in identifying and resolving financial risks Meanwhile, China will also initiate reform on the accounting system, strengthen self-discipline of the financial industry and encourage law firms, accounting firms and rating agencies to play active roles in supervising financial institutions And more importantly, the central bank will monitor the interaction between money market, capital market and insurance market from a macro perspective, so as to prevent financial risks and maintain financial stability To sum up, China will strive to establish a sound and highly efficient financial system with strenuous efforts and within a possibly short time frame so as to maintain macroeconomic stability and promote economic growth 25 ... globalization II Review of Institution Building in the Financial Sector A Main driving forces of institution building A review of the developments of China? ??s financial sector over the past 20 years reveals... unique role in institution building in the financial sector They help to mitigate financial repression in China, to establish sound financial system, to enlarge contribution of the financial sector. . .Globalization: the Role of Institution Building in the Financial Sector -The Case Study of China August, 2003 I Introduction Financial globalization could be described as a process in which